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Rising Rates May Slow Housing Bubble: Citi

NEW YORK (TheStreet) - Rising interest rates could slow the pace of home price appreciation unless incomes rise, Citigroup housing analyst Will Randow said in a report Friday.

This could actually be a good thing, according to the analyst.

"We believe that slower home price appreciation likely is healthy, compared to the recent 13% YoY jump in the S&P/Case-Shiller Home Price Index, as fast moving home prices could ultimately create another housing bubble (i.e. overvaluation) if interest rates did not respond as a governor," he said.

Interest rates have moved rapidly over the past month after Federal Reserve Chairman Ben Bernanke said the central bank may begin to wind down its massive bond- purchase program later this year, though it will keep short-term interest rates low until 2015.

Over the past month, the 30-year mortgage rate has risen from 3.35% on May 2, to 4.46% as of June 27.

The speed of the move has caught market participants by surprise and raised concerns about the sustainability of the nascent housing recovery, which has been fueled by rock-bottom interest rates.

Randow notes that despite the rise in interest rates, from a historical perspective, housing affordability is "still in good shape." He estimates mortgage rates need to rise to 6% to 7% before the family home price-to-income ratio is in parity with the 15-year average.

However, he does expect rising interest rates to dampen affordability levels. A 1 percentage point increase in mortgage rates would require $1,500 more in annual median family income to not impact housing affordability, assuming a 20% downpayment, according to the analyst. Or incomes need to grow 2% for every 1 percentage point rise in mortgage rates.

In the absence of a rise in incomes, affordability will likely take a hit, slowing the pace of home price appreciation.

Randow already sees signs home price gains will moderate in the next few months. Existing home inventory is already up 15% year to date and with rising prices, more upside-down homeowners are returning to positive equity and will be in a position to sell. So inventory will likely pick up in the coming months, cooling home prices.